Broken China and other Fragile Structures

The miracle of modern economic China has pulled half a billion people from subsistence poverty into a fast-growing market-based economy. These are the blessed citizens who have been able to migrate from the Chinese hard-scrabble interior to the dynamic coastal provinces and super cities. By repudiating the bankrupt economic policies of Marxism, the communist regime has unleashed a tidal wave of entrepreneurial growth, while still keeping a ruthless iron fist to suppress internal political, religious, ethnic and cultural dissent.

From 1980 through 2005, China’s average GDP grew by 8.6% per year. This works out to a 786% expansion in the economy, brought about by the replacement of soviet-style collectivist state-owned enterprises with privately-owned and mixed-economy companies. The average wage has risen from under $65 per month to over $6,000 per year.

Nearly all of these benefits have accrued to those fortunate souls who have been able to legally or illegally migrate to the coast from the center of the country. And salaries in Beijing are often many times higher than the average. Hundreds of millionaires and a few billionaires have made their fortunes within the past decade.

However, for the less fortunate billion people still trapped as serfs working under the old corrupt state-owned farming and factory system, life is brutal and people still scrape by on subsistence wages.

Which parallel-world China you live in, Coastal China I or Interior China II makes all the difference. Lately, the serfs of the command-economy China II have begun to grumble. And there are a lot of them.

The central government has been inflating the money supply faster than its real growth rate. By pegging the Yuan at an artificially low exchange rate of 7 Yuan to the US dollar, over a trillion dollars (one thousand billion dollars) has wound up in the state bank’s coffers as Americans are enticed to buy intentionally-underpriced products from the Chinese. In effect, China’s policies are subsidizing the American consumer, who benefits from a higher standard of living than would otherwise be possible. But such a policy is unsustainable in the long run — for both countries.

This 18th century producer mercantilist strategy to grow through cheap global exports has created enormous economic structural problems as hot money continues to pour into China. Boom after boom is followed by rounds of ever-growing busts. The stock market advances 100% in a year and then crashes back 50% in a few months. Real estate overbuilding is endemic in China I.

China’s money supply has now been growing by double-digits for a number of years. And inflation is having a severe impact on the vast hinterland. Rice has doubled and tripled in cost, and the poor interior can’t afford to pay the going market price. Food rationing of rice and other staples has begun in China II, soon to be followed by increased starvation, food riots and a crackdown by the army. The conventional socialist solution, likely to be applied – massive state subsidies and price controls – will only serve to prolong the agony and continue the shortages.

In the meanwhile, back on the coast in China I, China has been preparing for a global P.R. exercise, the 2008 August Olympics show-and-tell.

Once the last foreign visitor departs, the Central Bank will be forced to finally revalue the Yuan upwards. How much so is the 64 billion dollar question. Some analysts estimate that the Yuan is undervalued vis-a-vis the US dollar by as much as 60%. But even a 20% upward revaluation would wreck havoc with its economy.

If the Chinese-made plasma TVs, children’s toys and household items suddenly become more expensive for the western consumer, their demand will drop and substitutes from Indonesia, Thailand and Malaysia will appear to take over the market share. The result: closing factories and massive layoffs in the tens or hundreds of millions of workers and a serious economic crisis for China’s ruling elite.

The resulting reduction in domestic consumer purchasing power will drive down the demand for certain commodity imports including steel and aluminum. A global fall in many commodity prices will likely result as a knock-on effect.

The Chinese ruling clique is sitting on a running tiger. If the tiger suddenly brakes, they will be thrown off – and in danger of being eaten. One solution to this dilemma is to rapidly reposition the economy from primarily export-driven to domestic consumption.

Developing the infrastructure, rebuilding the creaking state railway system, and providing new modern power systems is necessary but not sufficient.

China is already building massive coal-fired electric power plants at the rate of one a week (so much for fighting so-called ‘global warming’). Within a decade, China is predicted to out-pollute the US and Europe combined. And Beijing is already a toxic city of massive factory and car pollution.

For the Olympics, the central government has ordered factories in Beijing and the 5 surrounding provinces, including Shanxi, to close for two months from late July to try and clean up the air so that western tourists will actually be able to see blue skies. Many residents of Beijing are being “encouraged” to visit relatives in distant cities so as to cut down on automobile pollution and lower the congestion. The sight of thousands of Olympiads wearing face masks (as much of the ordinary population now does) beamed to the billions of viewers worldwide would not help promote the Chinese self-image of a world power.

China needs to create a massive middle class of consumers, and fast, to enable its factories to continue to employ the legions of new workers migrating from China II and to transition away from the failed 18th Century mercantilist model to the truly free-market model as advocated by Adam Smith.

Whether it can do so in time remains to be seen – for the half-billion people who live in coastal China I as well as their billion poor cousins living in inland China II. Its success, or failure, will impact the world’s economy greatly and to a lesser degree the US economy as well.